T.C. Memo. 2003-185
UNITED STATES TAX COURT
PAUL AND PAULINE D. KESSLER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3281-02. Filed June 26, 2003.
Paul and Pauline D. Kessler, pro sese.
James N. Beyer, for respondent.
MEMORANDUM OPINION
RUWE, Judge: This case was submitted fully stipulated. The
stipulation of facts, the supplemental stipulation of facts, and
the stipulation of settled issues are incorporated herein by this
reference.
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On November 9, 2001, respondent issued a notice of
deficiency determining petitioners owed income tax deficiencies
of $17,097, $17,283, and $11,267 for the taxable years 1991,
1992, and 1993, respectively. Additionally, respondent
determined a $2,765 accuracy-related penalty pursuant to section
6662(a) for the tax year 1991.1
In the notice of deficiency, respondent made numerous
changes to items reported on petitioners’ returns for the
aforementioned years. After petitioners’ concessions,2 the
issues to be decided are: (1) Whether petitioners’ rental losses
for the taxable years 1991, 1992, and 1993 in the amounts of
$115,390, $48,974, and $21,309, respectively, are section 469
passive activity losses, and (2) whether petitioners are liable
for the section 6662(a) accuracy-related penalty for 1991.
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
2
Petitioners conceded the following: (1) They had
unreported rental income in 1991 of $55,000 which should have
been included on their Schedule E, Supplemental Income and Loss;
(2) their total claimed depreciation deductions should be
decreased by $1,590, $15,005, and $22,005 for 1991, 1992, and
1993, respectively; and (3) they had additional unreported
capital gains of $1,464 for 1992.
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Background
Petitioners timely filed their joint income tax returns for
1991, 1992, and 1993. Petitioners were owners3 and operators of
a subchapter C corporation named Pauline’s Concrete Pumping,
Inc.4 (Pauline’s Concrete). At the time the petition was filed,
petitioners resided in Philadelphia, Pennsylvania.
On February 15, 1987, petitioners in their individual
capacities entered into a “Master Lease Agreement” with Pauline’s
Concrete (the lease). The lease contemplated that petitioners
would provide certain equipment to Pauline’s Concrete and that
Pauline’s Concrete was responsible for all costs, including the
costs associated with the acquisition and maintenance of the
equipment and for all the insurance costs. The lease term was 10
years. Attached to the lease was an exhibit which listed the
following equipment contemplated by the lease:
3
For the taxable years at issue, petitioners were the only
shareholders of Pauline’s Concrete Pumping, Inc.
4
The stipulations filed by the parties use the names
“Pauline’s Concrete Pumping, Company,” “Pauline’s Concrete
Pumping Company, Inc.,” and “Pauline’s Concrete Pumping Inc.” It
is apparent that the stipulations refer to the same entity.
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Truck Description Unit Number
Mack 175K 1
Mack 514K 2
Mack 474K 3
Tag along 4
1989 Ford truck
1993 Ford truck
Various excavation equipment
Office equipment
In exchange, Pauline’s Concrete covenanted to pay petitioners for
the use of the equipment.5
For the taxable years 1991 through 1993, Pauline’s Concrete
was generally in the business of performing concrete pumping.
Pauline’s Concrete provided concrete pumping services and related
equipment at specific locations as requested by the construction
contractors.6 For the years at issue, both petitioners worked
for, and received wages from, Pauline’s Concrete. Petitioners
each drove and operated the equipment leased by Pauline’s
5
The lease states:
The lease payments (the “Annual Lease Amount”) shall be
calculated annually by Lessor based upon the number of
hours the trucks are in operation for the year at a
rate of $120 per hour, however, monthly payments (the
“Periodic Payment”) shall be paid in an amount as from
time to time may be periodically agreed between Lessor
and Lessee. * * *
6
As part of its operations, Pauline’s Concrete performed,
among other things, the following: Receiving phone calls to log
the pumping equipment on and off jobsites; deciding which pumping
equipment will be placed on which jobs; transporting the pumping
equipment to the jobsites; deciding when to replace older pumping
equipment; performing necessary maintenance on the pumping
equipment; and performing the safe operation of the pumping
equipment.
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Concrete at various jobsites.7 Petitioners were both responsible
for the management and daily operations of Pauline’s Concrete.8
During the years at issue, petitioners were also employed by
the same construction contractors for whom Pauline’s Concrete
performed concrete pumping services. These services consisted of
providing and operating equipment which would pump concrete to
the specific locations needed by the customers as part of the
construction process. The parties stipulated: “This payment
arrangement was used in order for petitioners to maintain their
union membership in the union, but more importantly to the
petitioners, to get paid for the services they performed.” The
contractors issued Forms W-2, Wage and Tax Statement, to report
payments made to petitioners in their individual capacities.9
For 1991, 1992, and 1993, petitioners reported their lease
activities on Schedules E, Supplemental Income and Loss, attached
to their joint income tax returns, on which they reported net
losses of $171,980, $63,979, and $43,314, respectively. For
1991, 1992, and 1993, petitioners received rental income under
7
Pauline’s Concrete employed approximately four to six
additional employees who also operated the leased equipment.
8
Additionally, petitioner Pauline Kessler performed
administrative, clerical, and secretarial duties for Pauline’s
Concrete.
9
Petitioners, in their individual capacities, received 20 to
30 Forms W-2, Wage and Tax Statement, each year from contractors.
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the lease agreement in the amounts of $55,000,10 $108,000, and
$184,702, respectively. With respect to the leasing activity,
for 1991 and 1992, petitioners claimed only equipment
depreciation deductions of $171,980 and $171,979, respectively.
With respect to their leasing activity, for 1993, petitioners
claimed deductions for interest expense and depreciation of
$44,538 and $183,478, respectively.
Discussion
Determinations of the Commissioner in a notice of deficiency
are presumed correct, and the burden is on the taxpayer to show
that the determinations are erroneous.11 Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). As a general matter,
deductions are a matter of legislative grace, and the taxpayer
bears the burden of proving entitlement to such claimed
deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
(1934).
1. Were Petitioners’ Rental Activities Passive Activities?
Section 469(a)(1) limits the deductibility of losses from
activities which are deemed “passive” activities. A passive
10
See supra note 2. On their 1991 return, petitioners
reported no lease income.
11
Sec. 7491, which shifts the burden of proof to respondent
in certain circumstances, does not apply because the examination
of the returns at issue commenced prior to the statute’s
effective date.
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activity is broadly defined as any activity involving the conduct
of a trade or business in which the taxpayer does not “materially
participate”. Sec. 469(c)(1). Rental activities are
presumptively passive activities, regardless of whether the
taxpayer materially participates. Sec. 469(c)(2), (4); Tarakci
v. Commissioner, T.C. Memo. 2000-358; Frank v. Commissioner, T.C.
Memo. 1996-177. A rental activity “means any activity where
payments are principally for the use of tangible property.”12
Sec. 469(j)(8).
Respondent’s argument is straightforward: Petitioners’
rental activities are passive in nature, and any losses therefrom
cannot be used to offset petitioners’ nonpassive income for the
years at issue. Thus, it is respondent’s position that the loss
deductions claimed on petitioners’ returns are currently
unavailable and are suspended until a future date when
petitioners have passive gains. See sec. 469(b). Petitioners,
on the other hand, assert that they are subject to one of the
exceptions to the presumption in favor of passive classification.
12
It is clear that petitioners’ leasing of equipment to
Pauline’s Concrete is a rental activity within the purview of
sec. 469. See Tarakci v. Commissioner, T.C. Memo. 2000-358;
Kelly v. Commissioner, T.C. Memo. 2000-32; Welch v. Commissioner,
T.C. Memo. 1998-310.
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The temporary regulations provide six exceptions to the
definition of rental activity.13 See sec. 1.469-1T(e)(3)(ii)(A)
through (F), Temporary Income Tax Regs., 53 Fed. Reg. 5702 (Feb.
25, 1988). Those exceptions are: (1) The average use of the
property by customers is 7 days or less; (2) the average period
of customer use is 30 days or less, and significant personal
services are provided by or on behalf of the owner; (3)
extraordinary personal services are provided by the owner in
connection with making the property available for use by
customers; (4) the rental of the property is incidental to a
nonrental activity of the taxpayer; (5) the taxpayer customarily
makes the property available during defined business hours for
nonexclusive use by various customers; or (6) the property is
provided by a partner or S corporation shareholder to his
partnership or S corporation. Id. Given the stipulated record,
we glean from petitioners’ brief that their argument is trained
upon the third and fourth exceptions listed above.14
13
The regulations were prescribed by the Commissioner under
the broad regulatory authority delegated to him by Congress
through sec. 469(l)(1).
14
Clearly, since the lease agreement by and between
petitioners and Pauline’s Concrete is exclusive, for a term of 10
years, and Pauline’s Concrete was a C corporation, the other
enunciated exceptions cannot apply.
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(a) The Incidental Exception
Although not clearly articulated in their brief, petitioners
apparently argue that their rental activity is incidental to
their nonrental activities, excepting them from the presumption
of passive characterization. See sec. 1.469-1T(e)(3)(ii)(D),
Temporary Income Tax Regs., supra. As it relates to this case,
the regulations “test” provides in pertinent part:
(c) Property used in a trade or business. The
rental of property during a taxable year shall be
treated as incidental to a trade or business activity
* * * if and only if--
(1) The taxpayer owns an interest in such
trade or business activity during the taxable
year;
(2) The property was predominantly used in
such trade or business activity during the taxable
year or during at least two or the five taxable
years that immediately precede the taxable year;
and
(3) The gross rental income from such
property for the taxable year is less than two
percent of the lesser of--
(i) The unadjusted basis of such
property; and
(ii) The fair market value of such
property. [Sec. 1.469-1T(e)(3)(vi)(C),
Temporary Income Tax Regs., 53 Fed. Reg. 5703
(Feb. 25, 1988); emphasis added.]
Petitioners presented no evidence that the amount of the rental
income earned for the years at issue met the 2-percent test. Cf.
Tarakci v. Commisioner, T.C. Memo. 2000-358. The record does not
establish the fair market value or unadjusted basis of the
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property leased by petitioners to Pauline’s Concrete.
Accordingly, petitioners have not shown they meet the
requirements of this exception.
(b) The Extraordinary Personal Services Exception
Petitioners argue in their brief that “the services * * *
[they] provide are personal in nature and not merely the rental
of concrete pumping trucks and equipment”. For purposes of the
extraordinary personal services exception, the temporary
regulations provide:
extraordinary personal services are provided in
connection with making property available for use by
customers only if the services provided in connection
with the use of the property are performed by
individuals, and the use by customers of the property
is incidental to their receipt of such services. For
example, the use by patients of a hospital’s boarding
facilities generally is incidental to their receipt of
the personal services provided by the hospital’s
medical and nursing staff. Similarly, the use by
students of a boarding school’s dormitories generally
is incidental to their receipt of the personal services
provided by the school’s teaching staff. [Sec. 1.469-
1T(e)(3)(v), Temporary Income Tax Regs., 53 Fed. Reg.
5702 (Feb. 25, 1988).]
Section 1.469-1T(e)(3)(viii), Example (3), Temporary Income Tax
Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988), illustrates this
exception:
The taxpayer is engaged in an activity of transporting
goods for customers. In conducting the activity, the
taxpayer provides tractor-trailers to transport goods
for customers pursuant to arrangements under which the
tractor-trailers are selected by the taxpayer, may be
replaced at the sole option of the taxpayer, and are
operated and maintained by drivers and mechanics
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employed by the taxpayer. The average period of
customer use for the tractor-trailers exceeds 30 days.
Under these facts, the use of the tractor-trailers by
the taxpayer’s customers is incidental to their receipt
of personal services provided by the taxpayer.
Accordingly, the services performed in the activity are
extraordinary personal services * * * and, * * *
[thus], the activity is not a rental activity.
In this case, petitioners are not engaged in an activity
which provides personal services to Pauline’s Concrete.
Petitioners simply own and lease cement pumping equipment to
Pauline’s Concrete. The lease is “net of all costs” to
petitioners.15 While petitioners clearly provide personal
services in their capacity as employees of Pauline’s Concrete
and, in their individual capacity, to construction contractors,
nonetheless, with respect to leasing equipment to Pauline’s
Concrete, the record reflects no provision for services incident
to such leasing activities. We hold that petitioners did not
provide extraordinary personal services within the meaning of
section 1.469-1T(e)(3)(v), Temporary Income Tax Regs., 53 Fed.
Reg. 5702 (Feb. 25, 1988). Accordingly, the activity is not
excepted from the definition of a rental activity.
Our opinion in Hairston v. Commissioner, T.C. Memo. 2000-
386, is instructive. In Hairston, the taxpayers owned heavy
construction equipment in their own names which they leased to
15
Under the lease, Pauline’s Concrete “shall pay all of the
costs associated with the acquisition and maintenance of the
leased property including the cost(s) of adequate insurance
sufficient to exculpate * * * [petitioners] from any and all
liability.”
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their wholly owned subchapter C corporation. The corporation was
in the business of leasing heavy construction equipment to
third parties. According to the lease agreement between the
taxpayers and their corporation, the corporation assumed all the
responsibility and costs for the equipment. Similar to this
case, the taxpayers claimed ordinary net losses. The
Commissioner determined that the taxpayers’ leasing activity was
a passive rental activity and denied the claimed deductions.
This Court analyzed the facts in light of the extraordinary
personal services exception and held that the evidence did not
establish that the taxpayers
in their individual capacities provided either
significant or extraordinary personal services in
connection with making their equipment available for
use either by * * * [taxpayers’] customer * * * [their
corporation] or for use by * * * [the corporation’s]
customers. * * * [Hairston v. Commissioner, supra.]
The Court explained that under the lease agreement, the taxpayers
were not obligated as owners of the equipment to provide any
services to their corporation or the end users. “Any services
that * * * [the taxpayers] might have performed as * * *
[corporate] officers or employees were unrelated to * * * [the
taxpayers’] obligations as owners of the equipment.” Id. Thus,
the Court concluded that the taxpayers did not qualify for the
extraordinary personal services exception. A similar result is
required here.
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Moreover, we cannot attribute the services provided by
Pauline’s Concrete to petitioners’ leasing activities. The
grouping rules are inapplicable because they only determine
whether a taxpayer materially participates in an activity, not
whether an activity is excepted from the definition of a rental
activity.
Section 1.469-4, Income Tax Regs.,
sets forth the rules for grouping a taxpayer’s trade or
business activities and rental activities for purposes
of applying the passive activity loss and credit
limitation rules of section 469. A taxpayer’s
activities include those conducted through C
corporations that are subject to section 469, S
corporations, and partnerships.” [Sec. 1.469-4(a),
Income Tax Regs.16]
The regulations provide: “One or more trade or business
activities or rental activities may be treated as a single
activity if the activities constitute an appropriate economic
unit for the measurement of gain or loss for purposes of section
469.” Sec. 1.469-4(c)(1), Income Tax Regs. Whether such
activities constitute an appropriate economic unit depends upon
all the relevant facts and circumstances. Sec. 1.469-4(c)(2),
Income Tax Regs.
Here, however, this attribution rule does not apply.
Section 1.469-4(d)(5)(ii), Income Tax Regs., states that: “An
16
Sec. 1.469-4, Income Tax Regs., applies only to tax years
ending after May 10, 1992. See sec. 1.469-11(a)(1), Income Tax
Regs.
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activity that a taxpayer conducts through a C corporation subject
to section 469 may be grouped with another activity of the
taxpayer, but only for purposes of determining whether the
taxpayer materially or significantly participates in the other
activity.” (Emphasis added.) See sec. 1.469-5, Income Tax Regs.
(regulations on what constitutes material participation). Since
we find that petitioners are not excepted from the general
definition of “rental activity,” we never ask the subsidiary
question of whether petitioners materially participated in such
nonrental activities. See sec. 469(c)(1); Tarakci v.
Commissioner, T.C. Memo. 2000-358; Welch v. Commissioner, T.C.
Memo. 1998-310 (“If petitioner establishes that the activity was
not a rental activity, he then must establish that he materially
participated in the activity to avoid the proscription of section
469.").
2. Accuracy-Related Penalty
Respondent determined an accuracy-related penalty of $2,765
for 1991 based solely upon petitioners’ failure to report rental
income.17 Prior to submission, petitioners conceded that they
had unreported rental income of $55,000 in 1991 which should have
been included on their Schedule E. Respondent’s determination is
presumed correct, and the burden lies with petitioners to
17
On brief, respondent states that he does not seek an
increase in the amount of the penalty determined.
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demonstrate that respondent’s penalty determination was in
error.18 Rule 142(a).
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment of tax attributable to, inter alia, any
substantial understatement of income tax. There is a
“substantial understatement” of tax if “the amount of the
understatement for the taxable year exceeds the greater of” (1)
10 percent of the tax required to be shown on the return or (2)
$5,000. Sec. 6662(d)(1)(A). An “understatement” means the
excess of the amount of tax required to be shown on the return
for the year over the amount of tax shown on the return. Sec.
6662(d)(2)(A).
Section 6664(c) provides an exception to the penalty imposed
under section 6662(a). “No penalty shall be imposed under this
part with respect to any portion of an underpayment if it is
shown that there was a reasonable cause for such portion and that
the taxpayer acted in good faith with respect to such portion.”
Sec. 6664(c)(1). “Underpayment” is defined as the amount by
which the tax imposed exceeds the excess of the sum of the amount
shown by the taxpayer on his return plus the amounts not shown
previously assessed over the amount of rebates made. Sec.
6664(a). The determination of whether the taxpayer acted with
reasonable cause and in good faith is made on a case-by-case
18
See supra note 11.
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basis, contemplating all the relevant facts and circumstances.
Sec. 1.6664-4(b)(1), Income Tax Regs.
Here, there is a substantial understatement of tax
attributable to petitioners’ failure to report rental income in
1991. The total understatement and the amount required to be
shown on the return was $17,097. The amount of the
understatement attributable to the unreported rental income was
$13,823.
There is no evidence in the record that respondent was
erroneous in the application and computation of the accuracy-
related penalty. Petitioners offered no argument or excuse for
their failure to report the rental income. Accordingly, we hold
that respondent was not erroneous in his determination of a
penalty. See Esposito v. Commissioner, T.C. Memo. 2001-131.
Decision will be
entered for respondent.